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Morningstar | State Street Reports Disappointing Results, Backs Off on Parts of Guidance; Lowering Our FVE

Wide-moat-rated State Street reported lackluster third-quarter results, as fee revenue was down again quarter over quarter, and up only 2% year over year. On the bright side, expenses were also down from last quarter, and the bank is still generating positive operating leverage year to date. Pretax income is still up 14% year to date. The return on average common equity was 14% for the quarter. Overall, we can understand the market’s worries about fee margin pressures, as many of the custody banks’ clients come under more intense pressure as well. We also believe that the Charles River Development acquisition will take time to play out, as State Street attempts to cross-sell different services, becomes more integrated with their offerings, and eventually onboards more complex deals. This, combined with the acknowledgement that the current bull market has gone on for a very long time, does not contribute to any positive sentiment around the name or the sector.

We have adjusted our estimates for State Street, expecting slower fee growth and less margin expansion as we acknowledge the secular and cyclical headwinds the industry faces. As such, we are lowering our fair value estimate to $90 per share from $100. This estimate is based on less than 100 basis points of margin expansion over the next five years, a slight deterioration in returns on tangible equity, and fee growth of only 2% after the CRD acquisition is completed. These are not optimistic numbers, and if State Street finds a way to stem pricing pressures with more integrated offerings, can control expenses, and if there is a more pronounced shift toward using the largest trust banks for more offerings throughout the industry, the bank could outperform these numbers.

We also point out that most of the businesses State Street is involved in are scale businesses, and State Street is usually the largest or second largest in many of its markets. This leads us to believe that even in a worsening operating environment, the bank will still have the scale to control expenses, and this will cushion the ultimate bottom-line impact. We also note that total percentage of expenses that State Street’s services make up on any of its client’s profit and loss statements is minimal, meaning that the benefit from bargaining State Street down to slightly cheaper rates tends to be small. These dynamics give us more confidence in our $90 per share estimate, and we would view a further trade-off as an opportunity.

On the positive side, assets under management were up strongly during the quarter, and more importantly the bank was making stronger gains in equity exchange-traded funds. While the equity-related inflows were strong enough to make net inflows a positive $8 billion for the period, net flows were negative for every other asset class. After excluding the effects of new revenue recognition standards, management fees were up only 1% year over year. We hope that with the renewed focus on the asset management side of the business, State Street can eventually reach a steadier state for all of its asset classes, although we recognize that pricing pressures will be a theme of the industry for years to come. Assets under custody and administration were up during the quarter, although the bank’s largest fee item, servicing fees, were down 1% year over year. This was largely affected by the loss of the BlackRock business, and adding that business back in to the quarterly run rate would have pushed growth to positive levels. Expenses, excluding one time items and revenue recognition changes, were up less than 1% year over year. This, combined with the positive growth in net interest income, led to margin expansion on a firmwide basis. The current environment is a tough one for the trust banks, and the overall derisking going on throughout the investment management world has not helped, but these things tend to go in cycles. In the end, the industry will still need several large players to help make the pipes work, and State Street will be around, enabling that to happen.